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A Definition of Liabilities in Internal Revenue Code Sections 357 and 358(D)

A transfer of property to a controlled corporation in exchange for the corporation's stock typically will not cause the transferor to recognize gain or loss on the exchange because of the nonrecognition provision of IRC Section 351. The transferor's basis in the stock received will equal the basis of the transferred property reduced by any liabilities that the corporation assumed or accepted in the transaction. IRC Section 358(d). If such liabilities exceed the basis that the transferor had in the transferred property, the excess will constitute gain to the transferor under IRC Section 357(c). The focus of this article is on the question of just what type of obligations constitute a liability for purposes of Section 357 and 358. Resting on a transactional analysis and on the history of the manner in which the Crane or Tufts doctrine was applied to obligations, the authors conclude that an obligation which would be deductible by the transferor when paid is not a liability as that term is used in those two Code sections. Citing this article and adopting its reasoning, a majority of the Tax Court reversed its prior position and excluded such obligations from those provisions. Focht v. Commissioner, 68 T.C. 223 (1977). Subsequently, Congress adopted the approach of this article when it added Sections 357(c)(3) and 358(d)(2) to the Code. The approach of this article was later extended by Congress to cancellation of indebtedness issues when Section 108(e)(2) was added to the Code in 1980.